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| IN THIS ISSUE – June 18, 2010 | www.bullmarket.com |
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Feature Article By NextInning.com: Member Q&A - Playing the Smartphone Tidal Change By BullMarket.com: Member Q&A: Teva By BullMarket.com: Best Buy Stumbles Over Increased Spending By BullMarket.com: Covidien to Purchase Somanetics
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Member Q&A - Playing the Smartphone Tidal Change The Droid Incredible seems to be a winner outside of the poor battery life. Assuming this is the beginning of a trend, I wonder who you see the winners and losers. Obviously it would hurt Research in Motion (RIMM) and help Apple (AAPL), Motorola (MOT) and HTC. Who else would be a winner or loser in such a switch? Is Google (GOOG) making any money off the operating system, or what is the GOOG play in the phone? A) You essentially asked two questions - one easy and straight forward and one that was very open-ended. It's those one sentence open-ended questions that are difficult to answer easily or concisely. Therefore, I'm going to tackle the easy questions first. I think the bad RIMM news has been fairly well discounted at least for the near term. I agree with you that in developed markets, particularly the U.S. market, RIMM is likely losing share to both Android and AAPL handsets. However, I believe it is building market share in emerging markets - at least for now. That said, in spite of the fact that I think the price of RIMM has dropped too far, I'm not speculating there - there is simply too much short pressure on RIMM to fight. I agree with your contention that AAPL, HTC and MOT are all well-positioned at this time - I have long positions in AAPL and MOT, but maybe not for the same reasons you like the potential for upside. While I think Droid is an upside for MOT, I believe the real story there is the pending split of the company - while it might get messy in the near term, I think once it is done and we have some short period of digestion, the world will say, "what took you so long" and Wall Street will show its appreciation. AAPL, of course, is a juggernaut at this juncture. An interesting side note on the new iPhone 4 is the fact that it uses the AAPL developed (Samsung manufactured) A4 processor. This is a multicore ARM Holdings (ARMH) design capable of running multiple applications simultaneously. However, the more interesting point here is that this is the first time we've seen any company of stature corner both the operating system and the hardware side of the value chain. It will be very interesting to see how AAPL leverages this going forward. However, that is certainly not the central issue for investors to consider in the model - while I think there is great potential value leverage there, the real story at AAPL and, for that matter, GOOG, is ecosystem leverage. I wrote last year when GOOG CEO, Eric Schmidt was still on the AAPL board of directors that AAPL and GOOG were on a collision course to become heads up competitors - not across the board, but as I noted last year, far more than a "brush of shoulders." There were a number of people who didn't agree with me when I wrote this last year, but I suspect those doubters are gone now. What's interesting at this juncture is the plot of the competitive course from here forward. GOOG's model is based on selling advertising and GOOG's strategy is to develop leverage points that play back to that model. A stark difference between the GOOG and AAPL models that investors should note here is GOOG gives away stuff to leverage the central model versus AAPL, which at this time, gives away absolutely nothing. AAPL has leveraged a very successful hardware / software model and is now using that to move into GOOG's advertising space. Personally, between the two, I'm comfortable holding my position in AAPL, but in spite of the fact that I could buy back the GOOG shares for roughly $70 less than I got when I sold them earlier this year, I have no inclination to do so at this time. Before we go forward to look for other ways to profit from these trends, I want to reiterate and clarify that I don't own AAPL or even MOT on the basis of them being handset plays. In the case of AAPL, I view it as an ecosystem play and in the case of MOT, as a turn-around play. While handsets are clearly part of the equation in both situations and I wouldn't likely be interested in either if I didn't like the handset positioning, my decision to hold the stocks is not centered on handsets. Your second question (the open-ended one), "who else would be a winner in such a switch" seems pretty straight forward, but it's really not. The real answer is this is not a point where we should draw our focus - it is a ripple on the water and what we're trying to parse is the timing and magnitude of a tidal change. I'm not sure what analogy best fits what we have today in the smartphone market - a baby step, a proof of concept or maybe its better viewed as the catalyst for change. Whatever it is it is just the beginning and to get from where we are today to where we're going will require many things to change - some radically. Due to this, my focus is to pick the companies that will benefit from the rising tide in the smartphone area and the tidal changes it is driving across many other technology platforms ranging from the broadband infrastructure that needs to be deployed to support real smartphone computing to the cloud data centers smartphones will leverage and on to a plethora of new software and security products that will bring "always-on" computing and the related M2M paradigms to life. Disclosure: At the time of this publication, out of the companies discussed herein, Paul McWilliams had long positions in AAPL and MOT.
Member Q&A: Teva A) We profiled generic drug maker Teva in late March when the stock was on a roll, concluding by saying, "Given its strong earnings power and cash flow, the stock isn't overly expensive, though we wouldn't be surprised if it saw a small retreat on some profit-taking in the near term after its recent jump in share price." Since then, the stock has fallen -18% through Friday's close, which is a little more than a small retreat. While the company's strong growth and inexpensive stock price are attractive, it does face some potential headwinds that could be behind its recent retreat. The obvious one is the problems in Europe. Once Teva closes its acquisition of Ratiopharm, the second-largest generics maker in Germany and the sixth largest worldwide, the company will derive approximately 33% of its revenue from Europe. Obviously the euro has plummeted, which will impact the attractiveness of the deal and its results moving forward. In addition, Western Europe is not known to be a big growth region. Meanwhile, Teva has one blockbuster branded drug, Copaxone, which is the leading drug for multiple sclerosis, with over $3 billion in annual sales. By 2011, the drug is expected to account for over 40% of its earnings. In a somewhat ironic twist, the company is facing multiple patent challenges from competitors -- Momenta (MNTA, $13.91, 0.16) and partner Novartis (NVS, $48.26, 0.01) and a separate one from Mylan (MYL, $17.95, -0.37) -- for a generic version of the drug. The drug currently has patent protection until 2015 and is a biologic, so we don't expect the company to lose its protection early, but it is a potential risk. Third, Teva has been very aggressively attacking patents and going through with at-risk launches. However, the company looks to have been too aggressive with its at-risk launch of a generic of Wyeth (now owned by Pfizer (PFE, $15.33, -0.13)) blockbuster Protonix in December 2007, and after losing an April 2010 court decision, it could be on the hook to write a pretty large check. Depending on how large the damages are, this could cause Teva to reevaluate its aggressive strategy, which has made it so successful in the past. BMR Take: The fall of the euro and its impending exposure to Europe is likely the biggest reason behind the decline in Teva's share price. The other two issues, meanwhile, are known potential headwinds that will likely keep Teva's multiple restrained despite its solid projected growth. Given its projected growth rate we think Teva looks attractive, but its increased exposure to the euro does worry us a bit. We think the stock can be accumulated on further weakness, but despite its many attractive qualities, the stock is by no means a slam-dunk. Teva was one stock we did consider adding to the Recommended List as the market pulled back, but the above reasons took us in other directions. However, we would put a target of around $62 on the stock.
Best Buy Stumbles Over Increased Spending "While there were positive signs in our results, this quarter’s earnings were below our expectations and that’s something I and everyone on this management team take very seriously," Dunn said. "There are two primary drivers behind these results. First, we experienced some variability in customer traffic in the U.S. over the course of the last three months, which resulted in a slightly lower comp than we were expecting. Second, we planned for higher SG&A during Q1 to accelerate some of the capabilities to sell more robust solutions for customers. However, our SG&A spend still came in higher than we had targeted for the quarter." Consumers, he went on to say, seem to be taking their cues from the broader economy, calling spending "episodic." "While spending clearly rallied from low levels of 2009, our data paints a picture of a consumer coming out to spend, and spend well, during important events but taking pauses in between. We can adapt to this environment and maximize the customer opportunity as the spending appears to run parallel to the economic recovery," Dunn told analysts. Best Buy reported a profit for the three-month period ended May 29th of $155 million, or 36 cents per share, compared with a year-ago profit of $153 million, also equal to 36 cents per share. Total sales grew to $10.8 billion from $10.1 billion during the prior-year period. The reported results were well short of the 50 cents in EPS that Wall Street analysts were forecasting on anticipated sales of $10.93 billion. Sales on a same-store basis grew by 2.8% for the quarter, against a year-ago drop of -6.2%. The gain included domestic comparable-store sales growth of 1.9% that was driven primarily by continued strength of connected business lines like Best Buy Mobile and mobile computing. The company said its core U.S. stores experienced strong sales of notebook computers, mobile phones, and appliances, while gaming, movies, and music were weak. It booked a low single-digit comparable-store sales decline in televisions that was driven by a high single-digit increase in unit sales offset by moderating price declines. Sales at Best Buy's direct-to-consumer online segment grew by approximately 26% in Q1. "I’m pleased with the 26% (online) revenue growth we achieved this quarter. We do not see dotcom as a separate channel for us, but think of it as a great complement to our store model," Dunn said. "Nearly 35% of the products we sell online in the U.S. are picked up in one of our stores. That’s a competitive advantage for us, especially versus our online only competitors. But more importantly, [it] allows us the additional benefits of leveraging our strengths of a blue shirt interacting with the customer when they come into the store, which gives us another opportunity to sell a complete solution." Management added that it expects gaming to rebound in the second half of the year, aided by motion-sensing games like Microsoft's (MSFT, $26.58, 1.09) Kinect product and firmware updates for the Sony (SNE, $28.89, 0.49) PlayStation. The company also announced that it would start a used gaming business in its U.S. stores this summer. Customers will be able to trade-in old games for credit towards different titles. The move takes aim at a market dominated by GameStop (GME, $20.71, -1.17). Outside of the U.S., comparable-store sales growth was 6.3%. Europe’s 5% comparable-store sales gain reflected strength in smartphones and post-paid connections. China had approximately 30% growth in comparable-store sales due to continued government stimulus activity and strong store execution, management said. Offsetting these gains was a -2% comparable-store sales decline in Canada, due to softness in consumer spending as market share in this business also remained stable. Despite the disappointing results, the company said it believed that it increased market share in a fragmented market. Best Buy is the only remaining publicly traded company focused on selling gadgets and electronics, but it does compete for consumer dollars with a host of regional competitors as well as the electronics departments at broader retailing giants like Wal-Mart Stores (WMT, $51.64, 0.40) and Target (TGT, $54.60, 0.55) and online-only sellers like Amazon.com (AMZN, $126.84, 3.01). Selling, general and administrative (SG&A) costs as a percentage of revenue swelled by 110 basis points to 23%. Management said approximately one-quarter of the SG&A increase was driven by currencies. Some of the growth was volume related and stemmed from the opening of new domestic big-box stores. The company is also opening new stand-alone Best Buy Mobile stores and has invested in a new online site for that business. Lastly, higher discretionary spending for IT projects, employee costs, and outside services drove a portion of the increase. "Our plan for the year included the expectation that the first quarter would be the high watermark for the year with respect to SG&A dollar growth," CFO James Muehlbauer told analysts. "We knew we would be undertaking a number of strategic and tactical projects as we prepared for the key selling seasons in the back half of the year." Muehlbauer said he expects the SG&A spending growth will slow as the year goes on. "Based on our current expectations of annual sales, we anticipate total SG&A dollars will increase by approximately 6 to 6.5% for the year, which remains consistent with our original plan," he said. "Bringing these assumptions together, we still expect full year consolidated operating income rate of approximately 5%, which reflects 30 to 40 basis points of growth from last year with the domestic business coming in at the top end of that range." The company reiterated that it expects EPS growth of 10% to 14% in the current fiscal year, driven by top-line growth and expansion of operating margin. BMR Take: This was clearly a disappointing quarter for Best Buy and shows the tentative nature of the recovery. Analysts point to the expense rise as a big source of concern as it makes the company more vulnerable to competition on price, which is how competitors like Wal-Mart, Amazon, and Target make their living. Trading at under 11x the midpoint of its fiscal-year guidance and under 10x next year's analyst estimates, the stock is inexpensive. However, the company is going to have to show that this quarter isn't the start of a trend. If the stock drifts to the mid-$30s, we think it can start to be accumulated by patient, value-oriented investors.
Covidien to Purchase Somanetics Somanetics' main product, the INVOS Cerebral/Somatic Oximeter, monitors the amount of blood oxygen in the brain and other areas for patients undergoing surgery or who are in critical care. The company also makes a bedside computer system for organizing clinical data. Somanetics had total sales of $50 million in 2009, and saw revenue jump 18% in Q1 to $13.1 million, while profits rose 57% to $2 million, or 16 cents per share. "The acquisition of Somanetics will allow Covidien to broaden our product offerings and add another market-leading monitoring technology to its portfolio," Pete Wehrly, Covidien's President of Respiratory & Monitoring Solutions, said in a statement. "The Somanetics product line, which we currently distribute in Europe, will expand our presence in the operating room. The acquisition will help us achieve our mission of enhancing the quality of life and improving patient outcomes." On an adjusted basis, Covidien said the deal is expected to be neutral to earnings per share in fiscal 2010 and slightly accretive in fiscal 2011. BMR Take: This deal continues Covidien's strategy of shedding slower growth businesses while acquiring fast-growing ones. However, as was the case with its pending purchase of ev3 (EVVV, $22.32, 0.00), the company is paying a hefty price. Over the long run, deals like this should help increase the company's sales growth and expand margins, but it's paying up to buy this growth and there are always integration risks. The fact that the company already distributes Somanetics' product line in Europe, however, should help on this front and give Covidien good insight into its potential. While currency will be a headwind, we continue to rate Covidien a "Buy" with a target of $53.
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